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January 25, 2010

On January 7, 2010, the Federal Financial Institutions Examination Council (FFIEC), a collection of federal regulators of financial institutions, issued an advisory on interest rate risk management. This advisory, which was issued as part of an effort to supplement and clarify existing interest rate risk (IRR) guidance provided by individual federal regulators, indicates that federal regulators will have increased expectations during future examinations of a financial institution’s management, modeling, stress testing and documentation of IRR.

In light of the current economic environment in which financial institutions are experiencing downward pressure on capital and earnings, FFIEC has grown concerned with the potential IRR associated with institutions funding longer-term assets with shorter-term liabilities in order to generate earnings. As a result, as part of future federal examinations, IRR assumed by a financial institution will be evaluated relative to the institution’s capital and earnings levels, and management will be evaluated on its efforts to identify, measure, control and document the institution’s IRR.

In particular, FFIEC reiterates its previous position that the ultimate responsibility for the financial institution’s IRR rests with its board of directors; as a result, the board of directors or a specially designated asset/liability committee “should oversee the establishment, approval, implementation, and annual review of IRR management strategies, policies, procedures, and limits.” The board of directors is expected to receive and review regular reports that allow them to accurately assess the IRR sensitivity of the institution to an increasing rate environment and to the important assumptions that underlie management-proposed IRR and liquidity projections. Further, the board of directors is directed to approve comprehensive written policies and procedures in place to monitor and manage IRR continuously. Although the advisory indicates that these processes and systems “should be commensurate with the size and complexity of the institution,” FFIEC indicates that “well-managed institutions” possess IRR management policies that include specific targets under a variety of short and long term scenarios.

The advisory further indicates that management should utilize modeling to determine the impact of changing rates on earnings, capital and liquidity. More specifically, FFIEC calls for institutions to evaluate the IRR of a particular transaction over multiple timeframes – immediate, two years, and five to seven years – and such modeling should incorporate both static and dynamic earnings simulations that quantify IRR exposure. Of these timeframes, the advisory emphasized that a two-year timeframe was often the minimum period necessary to accurately assess the institution’s exposure to a particular transaction’s IRR. Although the advisory encourages the use of modeling, it cautions that modeling alone cannot capture all potential IRR; because modeling provides only a snapshot of the risk involved in a particular transaction, the institution must evaluate IRR on a continuing basis.

To supplement the institution’s modeling, the advisory also encourages institutions to engage in regular stress testing that includes both scenario and sensitivity analysis. In terms of scenario analysis, the advisory de-emphasizes scenarios involving significant declines in market rates, in favor of increasing the following types of rising-rate scenarios:

Instantaneous rate shocks;

Rate shocks that occur over an extended period or periods;

Changes in the relationships between key market rates (basis risk); and

Changes in the slope and shape of the yield curve.

Although “non-complex” institutions may not need to conduct as many or as complex scenarios as many larger institutions, the advisory recommends that all institutions should incorporate shocks of at least 300-400 basis points into stress testing that measures many of the risks described above.

Further, all institutions are expected to use stress testing to evaluate the most essential assumptions used in their IRR modeling. The output of the institution’s testing will allow it to “document, monitor and regularly update key assumptions used in IRR measurement models.” While the advisory emphasizes that the results of the institution’s modeling and testing should be the basis for future assumptions, the advisory reiterates regulators’ well-known skepticism of brokered and Internet deposits. As a result, institutions should assume that these deposits should have “higher decay rates than other types of deposits,” especially if the institution projects future capital levels that would result in brokered and deposit rate restrictions.

The combined use of the institution’s projections and stress testing should result in limit controls that require specific action to mitigate IRR by the institution’s management should certain targets be met or surpassed. Although FFIEC does indicate that interest rate hedges and balance sheet adjustments can be useful tools for mitigating rising IRR, it warns that these risk-management options carry with them their own set of risks. For FFIEC, it appears that the most effective means of managing IRR is through the maintenance of robust regulatory capital levels.

The end result of the institution’s risk management efforts should be consistent validation of the assumptions, models, and limit controls – as the institution attempts to anticipate future risks, it must also evaluate its policies in light of actual events. These efforts should culminate in routine audits conducted by independent internal parties or an external auditor. The advisory specifically states that the results of these internal reviews should be made available to the relevant supervisory authorities during each examination.

Although the advisory indicates that it serves as only a “reminder” of supervisory expectations, it is clear that regulators will be evaluating the IRR management of financial institutions closely as part of future examinations. In particular, institutions should take care to document their efforts to model and stress test future risks, with special responsibility resting with the board of directors to be engaged in the formulation and analysis of the assumptions and benchmarks suggested by management. In addition, the advisory makes clear that additional regulatory scrutiny will be focused on institutions that currently have diminished capital or poor earnings, with excessive IRR potentially affecting the scope and extent of prescriptive remedial action taken by regulators.

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